––– a weblog focusing on fixed income financial markets, and disconnects within them

Thursday, May 14, 2009

Is your CDO Leaking

CDO noteholders, pay close attention to your monthly trustee reports. These are complicated deals and trustees make mistakes. Most of the time, these mistakes cost you nothing but every now and then they'll cost you millions.

For example, a mistake we picked up today revolves around an incorrect implementation of the “CCC Haircut Amount.” It's responsible for leaking approximately $4 million to equity when that amount should have been used to pay down senior notes.

The details...

Here's the definition from the O.M :

Click to enlarge

In simpler words, if this CDO has too many poorly rated assets then it has to carry a portion of these (“The Excess”) at market value (vs. par) when computing the numerator of this CDO’s overcollateralization tests. (The ensuing lower numerator increases the likelihood of an overcollateralization test trip. If such a trip occurs, cashflows that would have otherwise gone to subordinated tranches are redirected to pay down more senior tranches.)

Additionally, the definition specifies that The Excess should consist of those poorly rated assets with the lowest market values (this is typical) but the trustee made a mistake and picked the ones with the highest…

WHAT HAPPENED / WHAT SHOULD HAVE HAPPENED?

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This misapplication of the CCC Haircut Amount definition causes the class D overcollateralization test to pass when it should in fact fail. Because this test passes, cashflows are leaked out of the deal to equity when they should have been used to pay down the senior tranches in an effort to cure the failing test.

While this is the first distribution date during which the impact of this mistake is felt, chances are that the trustee will keep making it moving forward, ultimately sticking millions in losses to the wrong group of noteholders.

Here are the details of the CCC Haircut Amount calc.:

Click to enlarge

We’ve got a handful of these examples; we’ll try writing more of these in the future if there is an interest…